Mortgage rates have risen sharply over the past six months, leaving more than a million homeowners facing higher monthly payments this year when their current fixed contract ends.
For those with substantial savings in the bank, an offset mortgage could be a way to reduce those costs.
We take a look at how this type of home loan works and who could benefit the most.
Compensating interest: Compensating mortgages allow you to use your savings to reduce the amount of interest payable on your loan.
What is a Compensatory Mortgage?
A compensating mortgage essentially ties your savings account, or in some cases your checking account, to your mortgage with the same bank.
When you make a payment on your mortgage, the amount is “offset” against your savings account balance and interest is calculated on the difference between the two.
Depending on which bank you are with, you may be able to have several different accounts to tap into.
For example, if you had a mortgage of £200,000 and £20,000 in your linked savings account, you would only pay interest on £180,000 of the mortgage. This could save you thousands in interest over the life of the loan.
Money in your savings account won’t earn any interest, but it reduces the interest you pay on your mortgage, which could save you thousands of dollars over the life of the loan.
Your savings will not diminish over time and will be accessible at any time.
What are the advantages of using a compensatory mortgage?
The most obvious benefit is the savings you realize by paying a reduced amount of interest.
Hina Bhudia, a partner at Knight Frank Finance, says this type of mortgage can work well for “the self-employed and those who typically save throughout the year to pay their taxes as a lump sum.”
“It works for people who have money saved up, but that money isn’t working for them or is locked away,” she adds.
“Ultimately, if people have excess cash, it can be used to reduce the interest they pay on their mortgage payments.”
Compensating mortgages benefit those with significant savings that can be used against their loan tax-free
Opting for a compensatory mortgage could also benefit higher taxpayers with large savings balances. This is because you don’t pay tax on savings, because you reduce debt instead of earning interest.
“It could work for someone who has raised money for something like a home improvement project or even for school fees, where not all the money will be needed at first,” adds David Hollingworth of L&C.
“They can be deducted from the mortgage to avoid higher interest charges until the funds are needed.”
What are the disadvantages of a compensatory mortgage loan?
“If it sounds too good to be true, it is partly true. The privilege of an offset account is that it often comes with higher rates compared to standard mortgages,” says Nicholas Mendes at John charcol.
If you withdraw savings, you risk paying a higher rate on a larger proportion of the loan, thereby losing the cost savings.
So while you have complete flexibility as to whether you leave your savings in the clearing account or use them elsewhere, what you do will impact your mortgage payments.
You should also take into account that you will not earn interest on your savings during the term of the loan.
“If you think you might need to dip into savings, you’ll need to consider whether it’s better to take out a traditional mortgage or whether an offset works better. A good broker will be able to help with this,” says Bhudia.
What are the rates for Compensatory Mortgages?
Currently, the average rate on a compensatory mortgage is 5.45%, compared to the two-year market average of 5.32% and the five-year average rate of 5%.
“Although the rate is higher, if you have savings that aren’t generating a return equivalent to your after-tax mortgage rate, it’s still worth considering an offset product,” Bhudia says.
Another problem customers may encounter is the availability of these products.
There are currently 4,372 residential mortgage products available, but only 78 offset products are offered, compared to 88 at the same time last year.
Coventry Building Society is currently offering a five-year fixed contract at 4.71% with a minimum deposit of 25%. Accord has a comparable deal at 4.77% for a 40% deposit.
Why have mortgage rates increased?
Mortgage rates began to rise in December 2021, when the Bank of England began raising its base rate in an attempt to combat rising inflation.
However, this accelerated after the mini-budget at the end of September. The pound fell after then-Chancellor Kwasi Kwarteng announced several tax cuts that appeared unfunded.
Borrowing costs in the UK jumped as investors sold their UK government bonds – known as gilts – before the Bank of England stepped in by announcing a bond-buying program of £65 billion to shore up the market.
Up again: After gradually falling since January, swap rates are rising again and will impact fixed rate mortgages
After former prime minister Liz Truss resigned in October and new chancellor Jeremy Hunt canceled nearly all of the mini-budget announcements, markets calmed down and the cost of borrowing fell, mortgage rates also slowly decreasing.
However, it’s worth keeping an eye on prices as swap rates, the financial metrics on which most lenders base their mortgage prices, are going up.
Swap rates are an agreement between banks where they exchange one stream of future fixed interest payments for another stream of variable payments, based on a fixed price.
They tend to show where markets think mortgage rates are heading in the longer term and are factored into home loan prices.
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